We will provide you with narrative to enhance the PowerPoint presentation for each chapter of Financial Accounting by Libby, Libby, and Short.

Financial Statements and Business Decisions Chapter 1 Chapter 1: Financial Statements and Business Decisions

Understanding the Business Owner-Managers Founders of the business who also function as managers are called Owner-Mangers. Creditors Creditors lend money for a specific period of time and gain by charging interest on the money they lend. Founders of the business who are also managers are called owner—managers. In some circumstances, businesses borrow money from creditors. If the business is organized as a corporation, investors own shares of stock in the company. Investors Investors buy ownership in the company in the form of stock.

Understanding the Business Investors purchase stock (or ownership) in businesses hoping to gain in two ways: Sell ownership interest in the future for more than they paid. Receive a portion of the company’s earnings in cash (dividends). For corporations, investors purchase stock, hoping to gain in one of two ways. They may sell their shares of stock for more money than they paid for the shares or they may receive a portion of the company’s earnings in the form of dividends.

The Business Operations Manufacturers either make the parts needed to produce its products or buy the parts from suppliers. Manufacturer Final Product Customer A manufacture either makes the parts needed to produce its products or buys the parts from a supplier. Here we can see that the manufacturer produces prescription drugs, sells those drugs to a pharmacy, and the pharmacy sells to the final consumer.

LO1 Learning Objectives Recognize the information conveyed in each of the four basic financial statements and the way that it is used by different decision makers (investors, creditors, and managers). LO1 Our first learning objective in Chapter 1 is to recognize the information conveyed in each of the four basic financial statements and the way this information is used by different decision-makers (investors, creditors, and managers).

The Accounting System Reports information to decision makers Managers (internal decision makers) Reports information to decision makers Collects and processes financial information Investors and Creditors (external decision makers) The accounting system begins by collecting and processing financial information. This financial information is organized into reports that are distributed to decision-makers. The decision-makers may rely on the reports to make certain important determinations about the future.

The Accounting System Accounting System Financial Accounting System Periodic financial statements and related disclosures Managerial Accounting System Detailed plans and continuous performance reports External Decision Makers Investors, creditors, suppliers, customers, etc. Internal Decision Makers Managers throughout the organization A good accounting system produces information for financial reporting to external decision-makers. Those decision-makers include investors, creditors, suppliers, customers, union representatives, and all other interested parties. The system also should be capable of producing managerial reports that are used within the company to make determinations about pricing, production, quality, and numerous other day-to-day activities.

The Four Basic Financial Statements Income Statement Balance Sheet Statement of Cash Flows Statement of Retained Earnings The four basic financial statements include the income statement, the statement of retained earnings, the balance sheet, and the statement of cash flows. Financial statements summarize the financial activities of the business.

The Four Basic Financial Statements Companies can prepare financial statements at the end of the year, quarter or month. Many companies prepare financial statements on a monthly basis as well as on a quarterly and annual basis. Financial statements that are prepared at the end of the year are called annual reports. Financial statements prepared at the end of the year are called annual reports.

Let’s look at MAXIDRIVE CORP.’s financial statements. Let’s take a detailed look at the financial statements of Maxidrive Corporation.

1. Name of entity 2. Title of statement 3. Specific date 4. Unit of measure The Balance Sheet reports the financial position of an entity at a particular point in time. Almost all financial statements have a four-line title. The title includes, in this sequence, the name of the company, the title of the financial statement, the specific date covered by the report, and the unit of measure. Most financial statements of large corporations are usually rounded to the nearest thousand or million dollars. We can see in our example that the financial statements are presented in thousands of dollars. If we look at the cash account, the company has $4,895,000 in cash. The three zeros have been omitted. The balance sheet reports the financial position of the company at a particular point in time. In our case, the balance sheet reports the financial position at December 31, 2006. At the close of business on January 3, 2007, the financial position will likely change.

Assets = Liabilities + Stockholders’ Equity The Balance Sheet Basic Accounting Equation Assets = Liabilities + Stockholders’ Equity Economic Resources Sources of Financing for Economic Resources The basic accounting equation says that assets are equal to liabilities plus stockholders’ equity. Assets represent the economic resources of the company, and liabilities and stockholders equity represent claims against those assets.

Assets are listed by their ease of Assets are economic resources owned by the business as a result of past transactions. Assets are economic resources that are all owned by the business and are the results of past business transactions. In the balance sheet, we normally list assets in order of liquidity, that is, the ease with which the asset can be converted into cash. Accounts receivable are amounts owed to the company resulting from prior sales to customers. Inventories represent parts for products that are waiting to be sold to customers. Plant and equipment represent productive assets that are used to produce what we sell. Assets are listed by their ease of conversion into cash.

Liabilities are debts or obligations of the business that result from past transactions. Liabilities are debts or obligations of the business that result from past transactions. Accounts payable represents amounts the company owes to suppliers for items that have been purchased. Notes payable represent formal, written debt contracts. It is likely that a note payable would be due to a bank.

Equity is the amount of financing provided by owners of the business and earnings. Stockholders’ equity is the amount of financing provided by the owners of the business. Notice the accumulated undistributed earnings since inception of the business is included in stockholders’ equity. Contributed capital represents the shareholders’ investments. Retained earnings represents all earnings of the company that have not been distributed to stockholders.

Use $ on the first item in a group and on the group total. Assets = Liabilities + Stockholders’ Equity In conventional accounting, we use the dollar sign only at the top of a column and at the bottom, where the listed items are totaled. As you can see, we use a dollar sign for the first asset, cash, and another dollar sign for the total assets. Notice that the accounting equation holds true, that is, total assets are equal to total liabilities plus total stockholders’ equity.

1. Name of entity 2. Title of statement 3. Specific period of time (Unlike the balance sheet, this statement covers a specified period of time.) 4. Unit of measure Now let’s look at the income statement for Maxidrive. Notice that the financial statement properly tops the four-line heading with the name of the company, the name of the financial statement, the specific period covered, and the unit of measure. Income is measured over a period of time, and our income statement is for the year ended December 31, 2006. Once again, the financial statement is prepared in thousands of dollars.

The Income Statement reports the revenues minus expenses of the accounting period. The income statement reports revenues minus expenses for the period of time covered by the statement.

Revenues are earnings from the sale of goods or services to customers Revenues are earnings from the sale of goods or services to customers. Revenue is recognized in the period in which goods and services are sold, not necessarily the period in which cash is received. Revenues are earnings from the sale of goods or from providing services to customers. Revenue is recognized in the period in which the goods or services are sold, not necessarily the period in which cash is received.

Revenues Earnings from the sale of goods or services. When will the revenue from this transaction be recognized? Here is an example of the problems associated with revenue recognition. We made a sale on May 25, 2006 for $1,000. We did not collect the cash until June 10, 2006. Should we recognize the revenue in May, when the sale was made, or in June, when the cash was received? What do you think? June 2006 Cash from sale collected on June 10th. X May 2006 $1,000 sale made on May 25th.

Revenues Earnings from the sale of goods or services. When will the revenue from this transaction be recognized? The revenue should be recognized when the goods are sold or the services provided to the customer. In this case, we would recognize $1,000 worth of revenue in the month of May. $1,000 sale made on May 25th. X May 2006

Expenses are the dollar amount of resources used up by the entity to earn revenues during a period. An expense is recognized in the period in which goods and services are used, not necessarily the period in which cash is paid. Expenses represent the dollar amount of resources used during the period to produce the revenue. An expense is recognized in the period in which the goods or services are used, not necessarily the period in which cash is paid.

Some common expenses we would expect to find on an income statement include the following: Cost of goods sold represents the costs incurred to produce the product that is ready for sale to customers. Selling, general and administrative expenses are operating expenses not directly related to the production process. Research and development expenses are those costs the company incurs to bring new products to market. Interest expense is the cost of borrowed funds. Income tax expense is the amount owed to the taxing authority as a result of earned income in the current period.

Expenses The dollar amount of resources used up by the entity to earn revenues during a period. When will the expense for this transaction be recognized? Here is a common problem associated with expense recognition. In May, we pay $75 in cash to a newspaper for an ad that will run in June. On June eighth, the ad appears in the newspaper. Should we recognize the expense in May, when the cash was paid, or in June, when the ad appeared? May 2006 June 2006 May 11 paid $75 cash for newspaper ad. X Ad appears on June 8th.

Expenses The dollar amount of resources used up by the entity to earn revenues during a period. When will the expense for this transaction be recognized? We would recognize the advertising expense in the month of June, when the ad appeared in the newspaper. Until the ad appears, we have not received any service for the $75 we spent. Advertising expense recorded in June. X June 2006

If expenses exceed revenues, For many companies that are just starting operations, expenses often exceed revenue. When this happens, the company is said to have recognized a net loss rather than net income. If expenses exceed revenues, we report net loss.

1. Name of entity 2. Title of statement 3. Specific period of time (Like the income statement, this statement covers a specified period of time.) 4. Unit of measure Now let’s look at the statement of retained earnings for Maxidrive. As you can see, we have our four-line heading for the financial statement. The statement of retained earnings, like the income statement, covers a certain period of time. This statement of retained earnings is for the year ended December 31, 2006.

The statement of retained earnings is really quite short The statement of retained earnings is really quite short. It reports the way net income and the declaration of dividends affect the financial position of the company during the period. Net income increases retained earnings and dividends declared decreases retained earnings. The Statement of Retained Earnings reports the way that net income and the distribution of dividends affect the financial position of the company during a period.

Statement of Cash Flows Because revenues reported do not always equal cash collected. . . . . . and expenses reported do not always equal cash paid . . . net income is usually not equal to the change in cash for the period. We need the statement of cash flows because revenues are not always reported in the same period in which cash is collected, and expenses are not always reported in the period in which the cash is paid. It is highly unlikely that net income will be equal to the cash flows for the period.

1. Name of entity 2. Title of statement 3. Specific period of time (Like the income statement, this statement covers a specified period of time.) 4. Unit of measure Once again, the statement of cash flows has a four-line heading. Like the income statement and the statement of retained earnings, the statement of cash flows covers a specific period of time. This statement of cash flows is for the year ended December 31, 2006.

The Statement of Cash Flows reports the inflows and outflows of cash during the period in the categories of operating, investing, and financing. The statement of cash flow is divided into three major segments. The first segment reports cash flow from operating activities. The second segment reports cash flow from investing activities. The third segment reports cash flow from financing activities. Finally, we reconcile the beginning and ending cash balance.

Cash flows directly related to earning income are shown in the operating section. Cash flow from operating activities is directly related to cash produced from the operations of the business.

Cash flows related to the acquisition or sale of productive assets are shown in the investing section. Cash flow from investing activities is related to the purchase and sale of productive assets like property and equipment.

Cash flows from or to investors or creditors are shown in the financing section. Cash flow from financing activities represents amounts borrowed or repaid, as well as dividends paid to stockholders.

The statement ends with a reconciliation of Cash. The final section of the statement reconciles our beginning cash balance to our ending cash balance.

Relationship Among the Financial Statements Net income from the income statement increases ending retained earnings on the statement of retained earnings. Any income from the income statement increases retained earnings. So there is a direct relationship between the income statement and the statement of retained earnings. This means that we must prepare the income statement before we can successfully prepare the statement of retained earnings.

Relationship Among the Financial Statements Ending retained earnings from the statement of retained earnings is one of the components of stockholders’ equity on the balance sheet. The ending retained earnings balance appears in the stockholders’ equity section of the balance sheet. Again, we must complete the statement of retained earnings before we can successfully complete our balance sheet.

Relationship Among the Financial Statements The ending cash balance on the balance sheet is the cash balance at the end of the year on the statement of cash flows. So, the final statement to be prepared is the statement of cash flows. The change in cash on the statement of cash flows added to the beginning of the year balance in cash equals the ending balance in cash on the balance sheet.

Notes Notes provide supplemental information about the financial condition of a company. Three basic types of notes: Description of accounting rules applied. Presentation of additional detail about an item on the financial statements. Provide additional information about an item not on the financial statements. In addition to the basic information for financial statements, the annual report of the company also contains notes to those financial statements. The notes to the financial statements can be placed in one of three broad categories: First, notes can describe accounting rules used by the company. Second, the notes can provide the reader with additional detail about information in the financial statements. Third, the notes can provide additional information to the reader about information that is not included in the financial statements.

Management Uses of Financial Statements Marketing managers and credit managers use customers’ financial statements to decide whether to extend credit. Purchasing managers use suppliers’ financial statements to decide whether suppliers have the resources to meet our demand for products. Marketing and credit managers use financial information for purposes of preparing budgets or for determining whether or not to extend credit to a customer. A purchasing manager may use a supplier’s financial statement to see whether or not the supplier has the resources necessary to meet the company’s demands. Employees and union representatives may use financial information in contract negotiations. Employees’ union and human resource managers use the company’s financial statements as a basis for contract negotiations over pay rates.

Market Price (of the Company) Price/Earnings Ratio Price/Earnings Ratio = Market Price (of the Company) Net Income This ratio is one method for estimating the value of a company. A widely used ratio, published every day in the Wall Street Journal, is the price earnings ratio. To calculate the ratio, we divide the ending market price of the company’s stock by the reported net income. This ratio is one method that we can use to value a company.

LO2 Learning Objectives Identify the role of generally accepted accounting principles (GAAP) in determining the content of financial statements. LO2 Our second learning objective in Chapter 1 is to identify the role of generally accepted accounting principles, or GAAP, in determining the content of financial statements.

Responsibilities for the Accounting Communication Process Effective communication means that the recipient understands what the sender intends to convey. To have effective communication, those receiving the information must understand what the sender intended to convey. Informed decision makers need to understand accounting rules and accounting measurement practices to understand the message conveyed. Decision makers need to understand accounting measurement rules.

How are Generally Accepted Accounting Principles Determined? Our accounting system has a long and distinguished history. An Italian monk named Luca Pacioli, published the first elements of double-entry bookkeeping in 1494. Prior to 1933, the management of most companies were free to choose the accounting principles used to keep track of its transactions. Luca Pacioli, an Italian monk and mathematician, first published the elements of our double-entry bookkeeping system in 1494. Until the stock market crash of 1933, most companies decided on their own accounting principles. There was little uniformity or comparability of accounting information.

Generally Accepted Accounting Principles (GAAP) Securities Act of 1933 Securities and Exchange Act of 1934 The Securities and Exchange Commission (SEC) has been given broad powers to determine measurement rules for financial statements. The securities act of 1933 and the securities and exchange act of 1934 established the Securities and Exchange Commission. The Securities and Exchange Commission has the ultimate authority for establishing accounting rules and procedures.

Generally Accepted Accounting Principles (GAAP) The SEC has worked closely with the accounting profession to work out the detailed rules that have become known as GAAP. Currently, the Financial Accounting Standards Board (FASB) is recognized as the body to formulate GAAP. The securities and exchange commission has worked closely with the accounting profession to work out the detailed rules that have become known as GAAP. Currently, the securities and exchange commission permits the Financial Accounting Standards Board (FASB) to formulate generally accepted accounting principles.

Generally Accepted Accounting Principles (GAAP) Companies incur the cost of preparing the financial statements and bear the following economic consequences . . . Effects on the selling price of stock. Effects on the amount of bonuses received by managers and other employees. Loss of competitive information to other companies. Companies incur the cost of preparing financial statements. These costs must not exceed the benefits received by the company. Companies wishing to sell their stock to the general public must issue financial statements in compliance with generally accepted accounting principles. The preparation of financial statements is often necessary to determine bonuses received by managers and employees. On the negative side, widely available public information gives a competitive advantage to other companies in the same industry.

International Perspective Since 2002, there has been substantial movement to develop international financial reporting standards by the International Accounting Standards Board (IASB). Since 2002 there’s been a substantial movement to develop international financial reporting standards. This movement is controlled by the International Accounting Standards Board. It is an extremely difficult process to establish accounting rules that work in almost all industrialized economies. While some progress has been made, the international accounting standards board still has a long way to go in establishing international accounting standards.

LO3 Learning Objectives Distinguish the roles of managers and auditors in the accounting communication process. LO3 Our third learning objective in Chapter 1 is to distinguish the roles of managers and auditors in the accounting communication process.

Management Responsibility and the Demand for Auditing To ensure the accuracy of the company’s financial information, management: Maintains a system of controls. Hires outside independent auditors. Forms a board of directors to review these two safeguards. To ensure the accuracy of the financial information generated by the company, management must maintain a system of internal controls, employ the services of an independent outside auditor, and form an independent committee of the Board of Directors to review these two safeguards.

Independent Auditors Auditors express an opinion as to the fairness of the financial statement presentation. Independent auditors have responsibilities that extend to the general public. Overall, I believe these financial statements are fair. The independent auditor is hired to express an opinion as to the fairness of the financial statement presentation. Independent auditors are responsible to the general public for the opinions they render.

Independent Auditors An audit involves . . . Examining the financial reports to ensure compliance with GAAP. Examining the underlying transactions incorporated into the financial statements. Expressing an opinion as to the fairness of presentation of financial information. An independent audit is designed to ensure that the financial statements conform to generally accepted accounting principles. The independent auditor examines the underlying transactions to make sure that the compliance with generally accepted accounting principles exists. Finally, the independent auditor must reach some opinion as to the fairness of presentation of the financial statements.

LO4 Learning Objectives Appreciate the importance of ethics, reputation, and legal liability in accounting. LO4 Our forth learning objective in Chapter 1 is to appreciate the importance of ethics, reputation, and legal liability in accounting.

Ethics, Reputation, and Legal Liability The American Institute of Certified Public Accountants requires that all members adhere to a professional code of ethics. The American Institute of Certified Public Accountants requires that all members adhere to professional code of ethics.

Ethics, Reputation, and Legal Liability A CPA’s reputation for honesty and competence is his/her most important asset. Like physicians and lawyers, a CPA’s reputation for honesty and competency is his or her most important asset. Also like physicians and lawyers, CPAs are liable for malpractice. Like physicians, CPAs have liability for malpractice.

End of Chapter 1 End of Chapter 1.